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investor clinic

Now that the federal government is targeting swap-based ETFs, do you think they will do the same thing to covered-call ETFs? These ETFs pay a high yield that is tax-friendly and I am concerned that the revenue-hungry government will go after them next.

No, covered-call exchange-traded funds are almost certainly not in the government’s crosshairs.

In this week’s federal budget, the government specifically took aim at funds that use a method that “inappropriately defers tax or converts fully taxable ordinary income into capital gains taxed at a lower rate.” It also pledged to tighten existing rules “meant to prevent taxpayers from using derivative transactions to convert fully taxable ordinary income into capital gains taxed at a lower rate.”

One of the government’s main targets is swap-based ETFs, which defer tax to unitholders by effectively converting dividends and other income into capital gains that only become taxable when the units are sold. These products, also known as total return ETFs, are popular in non-registered accounts because they deliver the same total return – including dividends – as the index they track while avoiding the annual tax hit.

But covered-call ETFs are a different animal. These ETFs generate additional income by selling (or “writing”) call options on a portion of their underlying securities. A call option gives the buyer the right to purchase the shares at a specified price before a specified date. They’re known as “covered” calls because the ETF owns the stocks on which the option contracts are written.

Because covered-call ETFs collect premiums when they sell options, they can pay a higher yield than an ETF that doesn’t use a covered-call strategy. It’s not a free lunch, however, because in a rising market, the ETF will often have to sell stocks to the option holder at the agreed-upon price, which limits the upside potential of the ETF.

But unlike swap-based ETFs, covered-call ETFs don’t defer tax. The premium income is paid out to unitholders and taxed as capital gains in the year it is received. Dividends and other income are also paid out and taxed annually, so there’s little incentive for the government to go after these products.

“The proposed changes in the legislation had absolutely no impact on any covered-call strategies in Canada,” Mark Noble, senior vice-president with Horizons ETFs Management (Canada) Inc., said in an interview.

Horizons has published a list ( of several dozen ETFs – including derivative-based products that let investors bet on the direction of commodities – that could be affected by the proposed legislation, but none of Horizons’ eight covered-call “enhanced income” products was mentioned. Similarly, Bank of Montreal said six of its “TACTIC” mutual funds could be affected by the proposed legislation and the bank has therefore suspended new purchases of the products. But none of BMO’s covered-call ETFs was on its list, either.

“While I have never liked covered call funds – because they accept a good majority of the downside while giving up the vast majority of the upside – investors have nothing to worry about as a direct result of this week’s budget,” Dan Hallett, vice-president and principal with Highview Financial Group, said in an e-mail.

Where can I find out if a company’s dividend is eligible for the enhanced dividend tax credit? I got caught with A&W Revenue Royalties Income Fund (AW.UN).

Your best bet is to read the news release announcing the company’s latest dividend. The release – usually available in the investor relations section of the company’s website – will indicate whether the payment is an “eligible dividend” (which is the case for most publicly traded Canadian companies) or an “non-eligible dividend” (as is the case with A&W). The good news is that non-eligible dividends still qualify for a tax credit, but it’s not as generous as the enhanced dividend tax credit. Also keep in mind that some distributions – such as those from real estate investment trusts – may not contain any dividends at all, but usually include a mix of fully taxable income, capital gains and return of capital.

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